The financial industry has managed to confuse investors by implying that stocks are attractively valued based on their forward price-earnings ratios. This according to Joachim Klement, CFA, in a July issue of Enterprising Investor.
Klement argues that many investment reports and financial media pundits claim that a stock is “attractively valued because its forward P/E is such and such,” but studies on value factors are actually conducted using trailing price-book and price-earnings ratios. “Recognizing the difference,” he says, “is critical to becoming a successful value investor.”
To support his argument, Klement compared the average returns of index stocks (chosen from the four major market indices) to those of stocks with the highest P/E ratios going back monthly for the past 20 years. He first used trailing 12-month P/Es and then switched to forward 12-month figures. What he found was that, in the U.S., the cheapest quintile of stocks based on trailing P/E outperformed the most expensive by 1.2% per year. When using forward P/E ratios, Klement found that “the most affordable stocks underperformed the priciest by 1% annually.” He found that the results were similar (albeit less dramatic) in overseas markets.
Why don’t forward P/Es work? Klement explains that it’s due to the fact that analysts are overly optimistic and “simply inept at predicting company earnings.” To emphasize the point, he quotes the legendary value investing guru Benjamin Graham: “While enthusiasm may be necessary for great accomplishments elsewhere, on Wall Street it almost invariably leads to disaster.”